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Trade, Trade, Trade

Financial Insights

Equity prices have been unusually volatile the last two weeks.  But there’s been little net progress as markets bounce up and down in tune with the latest set of rumors and prognostications in the press.  Congress has been in recess this month, which has left a quasi-vacuum of real news that has been filled with speculation, predictions and downright false interpretations of events.  The chart below illustrates the essentially net zero result of recent trading by the DJTMI, which has been bounded by roughly 30,000 and 29,000 for most of the past two weeks.

 Source:  MarketQ quotation platform, www.esignal.com

The press has been shouting, “Recession!” Leaks suggested the recent G-7 meeting was going to be a chaotic denunciation of President Trump and the tariff war between the US and China heated up before suddenly cooling.   The unpredictability and pace of news has driven repeated sharp rallies and declines on Wall Street.  Investors can be forgiven for shaking their heads in amazement as a daily barrage of news, rumors and tweets is reflected almost instantaneously and forcefully in equity prices.

We addressed predictions of a coming recession in our last post and subsequently, nothing has emerged challenging the conclusion that a dramatic economic slowdown in the US is not looming.  It is true that outside the US, conditions are weak and deteriorating.  But we see no domestic economic or sentiment indicators suggesting similar conditions are in the offing at home.  Statistical measures of the health of the US economy are prone to fluctuation but it is disturbing to witness the reaction of pundits to any individual number as a harbinger of economic doom.  Trends of growth and low inflation remain intact.  

Trade conflicts moved to a new level this past weekend at the G-7 in Biarritz, France as real news and some surprising developments were announced.  Notably, Japan and the US reached an agreement in principle that will entail Japan purchasing an estimated $7 billion of agricultural products from the US, including soybeans and corn.[1]  Both crops have been targeted by the Chinese with tariffs.  

Almost simultaneously, conciliatory messages from the Chinese calling for a de-escalation of tensions with the US were rumored to have been received.  This, however, was denied by China, but certainly would not be particularly surprising if it had in fact occurred.  The main leverage the Chinese have had in the negotiations was withholding purchases of US agricultural products such as soybeans and corn.  Japan’s agreement to purchase excess US crops pulled the rug out from under the Chinese.   Talks are scheduled to resume in early September.[2]

Imbalances in the credit markets continue.  Inversion of the Treasury yield curve is ongoing and expectations in the futures market of another ¼% Fed Funds rate cut next month are pinned at 100%.  The disparity between the shortest rates and the 5 year note, however, indicates that the presumed reduction in the Fed’s target rate to 1 ¾%-2% will not return the curve to its normal upward slope.  

Short term interest rates remain above the annualized inflation rate, which, at present, is a nominal brake on lending activity.  In our view, it is incumbent on the Fed to allow the curve to normalize to avoid unintended consequences in the banking sector of the economy.  The “borrow short, lend long” basis of banking profitability could easily be jeopardized should current small or negative spreads between short, intermediate and long term interest rates remain.  

At this writing, 30-year Treasury bond yields are trading under 2%, below the lower end of the Fed’s short term target range of 2%-2 ¼% and trading nominally below the current 3-month T-Bill yield.  It is difficult to imagine this scenario persisting much longer.

Washington DC is traditionally quiet this time of year, but on the campaign trail, Democrat Presidential candidates are introducing myriad plans of action to be implemented should they become President.  At this relatively early juncture in the process, equity and bond market investors appear to be paying little attention to the river of news and proposals flowing from the candidates.  This will likely change later this year as primary voting gets underway and the unusually large field winnows itself.

When we began this post, we anticipated inserting a brief discussion of various recent political events in Europe but developments in Britain over the past 24 hours have supplanted our intentions.

Boris Johnson succeeded Theresa May as leader of the Conservative party in late June and in mid-July, as UK Prime Minister.  The fall of Mrs. May’s government was apparently the direct result of her failure to effectively implement the June 2016 referendum mandate to leave the EU by the end of March 2019.  

Adding to her woes was Parliament’s thrice over rejection of her negotiated Withdrawal Agreement (WA).  Mr. Johnson, immediately upon taking office, expressed an unwavering intent to consummate Brexit on October 31.  However, in the weeks since, the new PM has hinted that he may be willing to “modify” the WA instead of proceeding toward a clean break with the EU, establishing trade with partners under World Trade Organization (WTO) rules.

On Tuesday, August 27, the Brexit party, which is less than 5 months old, held an extraordinary meeting in clear reaction to Johnson’s perceived waffling.   The assembly included candidates ready to stand for every seat in the House of Commons should a General Election (GE) be called in November.  Nigel Farage, the party’s leader, stated in no uncertain terms that should Brexit not occur and the UK revert to WTO rules on October 31, the party will vigorously oppose Mr. Johnson’s government and call for a GE in the first week of November.   

On the other hand, if Mr. Johnson remains true to his word and Britain exits on October 31, the Brexit party has pledged to support him and will expect to help deliver a strong Parliamentary majority for the Conservatives.   Recall that the May EU Parliament elections resulted in the Brexit party becoming the largest single party represented in that body, so Mr. Farage’s comments do carry weight.

In the wake of this presentation and the resolve expressed by Mr. Farage, this morning, August 28, roughly 24 hours later, Mr. Johnson announced that when Parliament returns to work next week, he will call for a dissolution of Parliament by the Queen the following week.  This bold move has clearly caught the Remain opposition off guard.  There will now be virtually no chance that a negotiated WA can be ratified by Parliament and assures a new GE immediately after the October 31 Brexit deadline.

The rapidity of these events is staggering and has effectively rendered impotent any further Remain resistance to Brexit.  It cannot be a coincidence that the ability of a new party to field an entire slate of candidates for a GE was demonstrated 24 hours before Mr. Johnson’s action.  This is the US equivalent of a new party forming 5 months before a Congressional election and producing credible candidates for all 435 House of Representatives seats.   Simply inconceivable.

We watched the Brexit party assembly live and feel comfortable asserting that the likelihood of a no-deal Brexit has increased exponentially in the past 24 hours.  Mr. Johnson’s decision today supports this conclusion.

The UK is the 5th largest economy on the planet and one of the US’s largest trade partners.  President Trump’s meeting with PM Johnson at last weekend’s G-7 laid the groundwork for quick evolution of a new bilateral trade agreement with the UK post-Brexit.   With assurance of support from the US, Johnson’s willingness to take bold, decisive action to fulfill the voter’s 2016 mandate appears to have solidified.  The next month in British politics will be very interesting.

The rapidity of news releases and rumors concerning trade relationship negotiations across the globe has obviously contributed to volatility in US equity markets.   However, taking a few steps away from the fray, it is important to remember that despite ongoing uncertainty, US equity markets retain solid double digit gains for the year to date.   

Should anyone doubt the inadvisability of concentrating on day to day press accounts and projections about trade, the markets and the economy when making investment decisions, the last several weeks are instructive.  World trade is likely to remain a focus of investors for the foreseeable future, but a longer view is that markets are perceiving the potential for new or renegotiated bilateral agreements positively.

[1] “U.S. and Japan strike trade deal ‘in principle’,” www.politico.com, August 25, 2019.

[2] “Trump insists trade talks have restarted with China, but details are elusive,” www.washingtonpost.com, August 26, 2019.

This content is developed from sources believed to be providing accurate information. The opinions expressed and material provided are for informational and/or educational purposes only and is not, in any way, to be considered investment advice nor a recommendation of any investment product. Advice may only be provided by DWM's advisory persons after entering into an advisory agreement and provided DWM with all requested background and account information.